Wednesday, November 16, 2011

Is America's financialization China's fault?

This morning, as I read the latest big expose on the continuing financialization of America's economy (this one courtesy of the excellent Amanda Terkel), I once again felt the insistent tug of a question that has been worrying at my brain for quite some time now: What is the root cause of financialization?

Financialization is real, and has been huge. For a thorough discussion of the phenomenon and an overview of related research, see Wouter den Haan. But the basic story can be grokked in two graphs. First, here's the finance and insurance industries as a percentage of all value added in the U.S.:

Now here are finance-industry profits as a percent of all corporate profits:

When we see a shift this big, there are two natural explanations. The first is that financialization is a natural and inevitable part of economic development. The second is that something big in the global economy is causing the shift.

Intuition says it's a combination of the two. Most advanced nations see a shift toward "services" as their economies mature; this is even true of Germany and Japan, where manufacturing is almost a religion. And there is an intuitive explanation for this: as catch-up growth and "extensive" growth peter out, owners of capital place a higher premium on ferreting out new investment opportunities - companies with new technologies, companies with new trade opportunities, and investment opportunities in developing countries. The industry that sniffs out those opportunities for uninformed rich people is the finance industry.

But there is also reason to believe there are "shocks" at work. Go back before 1945, and you'll see finance making up a relatively high percentage of America's economy during the first two decades of the 20th century. This suggests that there are contingent factors at work...and the obvious culprit is globalization, which ballooned in the early 20th century, collapsed during WW2, and then began a long steady rise after the bombs stopped falling.

How could globalization enable America's finance industry to take over America's economy? We have all heard of the "demand-side" factor here - the idea that America, with its "deep" and "liquid" financial markets, simply has a comparative advantage in managing money relative to other countries, and hence other countries beat a path to our door to get our banks and hedge funds to manage their money for them. In this story, globalization mainly acts as an enabler; reducing barriers to international capital flows simply allows the world to access our financial markets.

This was the dominant story leading up to 2008, and I instinctively distrust any story that was dominant leading up to 2008. Since then, there have been rumblings of another story of why globalization might have caused financialization - a story about the supply of capital rather than the demand for returns. This is an extension of the "savings glut" story that Ben Bernanke was telling during the 2000s as an explanation for our trade deficit: China and other exporters wanted to pump up exports, so they kept their currencies cheap. This required buying a lot of dollar-denominated assets (in practice, this meant Treasuries), which flooded America with cheap capital. This simultaneously made American manufacturing less competitive, and created profit opportunities for American financial firms via low interest rates that let them lever up.

The 4% of GDP trade deficit that we have on average run over the past decade is best viewed as yet another shift of the US economy into the insurance industry: in this case, a shift inro the "industry" of providing political risk insurance...the only reliable way we know for a poor country to become richer is...by exporting low and relatively simple manufactured goods to the rich...That requires a low value look for the...currency. And that requires that the government manipulate the currency by buying large amounts of dollars...Developing country governments, especially in Asia, think that this political risk insurance policy is well worth buying...The question, however, is whether this American specialization in finance and in the sale of political risk insurance is truly intelligent. Are these the "industries" of the future? Or is this rather a path that leads to a dimmer future for middle-class America?

DeLong explicitly links the trade deficit to financialization. This argument has a lot of intuitive appeal to me - partly, I admit, because of my general dislike of China's currency policy. If China's mercantilism is causing our financialization, that's one more reason to fight back. It would be cool if I could write "The Occupy Wall Streeters should be demanding that we pass the yuan bill!"

But to be intellectually honest, I have to admit there are some obvious problems with the hypothesis. One is that, although the profit-based measure (second graph above) shows financialization exploding after 2000, the value-added measure (first graph), rose steadily since WW2 and then actually leveled off after 2000. So the correlation of Chinese surpluses with American financialization depends on what measure you use for the latter. A second problem with the theory is that there was also some degree financialization in the 1920s, when America was running big current-account surpluses (much like China is today).

So I'm left without a clear conclusion. Are there good studies out there that look at the correlation between a nation's capital flows and the size of its financial sector? I can't find any, but perhaps they exist. If you know of one, please let me know.

10 comments:

This is a question that bugs me as well. But I think an international comparison might suggest that the trade balance in not a central factor (buying huge loads of treasuries doesn't actually do much for the size of the financial sector - its very cheap in terms of resource use).

My guess is that has to do with two factors. 1. The fashion in ango-saxon countries for running tight fiscal policy and relatively loose monetary policy which automatically pushes up private sector leverage. This if you like is a MMT perspective.2. Overvalued exchange rates leading to a lack of real investment opportunities - which tends to result in financial asset booms as investors look for yield.

I would take it that leverage and speculation lead to consolidation and consolidation leads to greater opportunities for outsourcing (specialization) in genereal including offshoring (especially cheap labor). The relatively low tax burden on capital gains returns over an investment holding time window compared to interest and dividend income over such time leads to greater trading and speculation and eases consolidation of wealth and corporations. During the twenties credits on dividends tax for the corporate rate side of the double tax on dividends lessened the differential between the returns on selling and holding and credit was not big enough for leveraged offers, but soaring exuberance and the absence of limits on bank reserves stored in stock equity created a mighty bubble. So, there were other conditions that were different between then and now. So, like robbing a bank you look to finance because that is where the money is regardless of how capital and leverage are being distorted to the detriment of real economic productivity.

Take a look at the University of Gronigen's data on FIRE employment and value added versus manufacturing for about 30 developed and developing countries. The inverse relationship holds almost everywhere: FIRE rises when Manf. falls and the revers. The data for South Korea and Japan ARE AWESOME -- especially S. Korea: In the pre-developmental state 1950's Korea had a bloated FIRE sector: After General Park Chung Hee seized power and heads rolled, the FIRE sector falls like a rock: and the Korean economic miracle is born...

I would guess from that data that the size of the financial sector is related to the degree of wealth inequality. Intuitively that's what makes sense to me -- the business of the financial sector is borrowing from those who have money and don't need it and loaning to those who don't have money and could use it, so the more inequality, the bigger the mismatch between where the money is and where it will be used, the more opportunity for the financial sector.

It sort of looks like finance's share of profits really takes off right at the end of Volcker's disinflation. I guess it makes sense that higher inflation benefits industries with fixed assets relative to finance. And maybe credit rationing ain't such a bad thing...

"The first is that financialization is a natural and inevitable part of economic development."

Uh, if that were true, why is the period where financial profits move around an equilibrium a period of higher growth than the period where "intermediation" takes a greater share of the economy?

I'll readily grant you that when you're well short of Kuznets Curve considerations, things such as growing access to financial intermediation, minimum wage, and employment protection are essential to growth. But the US of the late 1970s onward is not that model.

The two major proximate reasons for the 2000 ff. spurt are the 2000 CFMA and the 2005 Biden Bankruptcy Bill, the first of which gave a full imprimateur to widespread gambling and the second of which gave it precedence (not just pari passu, but precedence) over real obligations. China is, at best, a distraction, usable as trompe l'oeil so that you don't see that the other hand is cheating you.

I would be interested in seeing a breakdown by sub-sectors of the financial industry: banking, fire insurance, life insurance etc. It is hard to believe that finance could sustainably produce 25% to 33% of all corporate profits.